Liquidity risk refers to the liquidity of the asset or investment that you own. It can refer to two different things.
One, can the company quickly create cash so as to pay its obligations?
Two, how quickly can you buy or sell an asset and is there a trade-off between price and time?
In general, liquidity is the ease in which you can acquire or dispose of an asset. By ease, both the timing and the pricing. The greater an asset’s liquidity, the easier it is to trade in speed and proximity to fair market value.
Today we will look at the first point.
Business Liquidity
For a company, liquidity means how easy it is raise cash to pay its obligations.
The closer an asset is to its cash base, the more liquid. The more difficult an asset is to convert to cash, the less liquid.
If a company has $10 million in assets and only $1 million in short term obligations (i.e., those due in less than one year), the company seems in very good shape. A 10:1 asset to debt ratio is a strong positive for most business. At least in the liquidity context.
However, consider three companies with that exact profile. ABC has its $10 million in assets split equally between cash and its plant and equipment. DEF has $0.5 million in cash, $4.5 million in inventory, and $5 million in plant and equipment. GHI meanwhile has $0.1 million in cash and $9.9 million in a real estate development that will not be completed this year.
All have significantly more assets than debt, but all are in very different liquidity positions.
ABC can easily pay off its debt as it has the cash already on hand. Unless ABC suddenly decides to spend or distribute all its cash, there should be no liquidity problems.
DEF has some cash on hand, but not enough to pay all its current debts. DEF must hope that enough sales are made from inventory prior to its obligations coming due to ensure payment can be made. If sales are slow, DEF may need to lower their prices in order to create stronger customer demand (and sales) so as to be able to pay their liabilities. But given their needs, their liquidity issue is not severe.
Now GHI does have some potential problems. They have very little cash on hand and their assets are tied up in a long term project that will generate no short term positive cash flow. GHI will not have sufficient funds to meet their obligations. To meet their needs, and avoid potential bankruptcy, GHI may need to borrow money from a financial institution or sell part of their real estate project. GHI might also issue debt or equity to the public. However, the time it takes to float either issue might take too long to be a practical alternative.
When analyzing companies for investment purposes, always think a few steps ahead. Do not simply be satisfied with surface results. Always dig deeper.
In this example, all three companies have strong asset to debt ratios. But, in reality, each company is very different with its liquidity situation.
That is a drawback with quantitative analysis. Numbers seldom tell the entire story.
Short Term is Key to Liquidity
Another takeaway from this example is to always be sure and compare apples to apples.
Assets and liabilities may be short, medium, or long term in nature. When looking at short term obligations, you need to compare them to short term assets.
Short term in investing typically refers to assets or liabilities of under one year in duration. For assets, the asset will be converted to cash within a year. For liabilities, the obligation will be paid within a year.
They are also called current assets or current liabilities.
Cash is already cash. Unless there are imposed restrictions, you can do whatever you want with cash. It is fluid like tap water. It is fully liquid.
Other current assets are more like ice cubes. You need time for them to warm up and turn from solid to liquid form.
Accounts receivable, inventory, and prepaid expenses are the usual current assets. Most accounts receivable on sales will be paid within 90 days, so they become cash within the year. Product inventory tends to turnover (i.e., be sold and replaced) within one year and turned into cash, so it is also considered a current asset.
Prepaid expenses differ in that you have already paid out the cash. However, you get the benefit over the coming period. And technically, an asset is anything you own that is expected to bring you an economic benefit in the future.
An example of a prepaid expense would be office rent that you pay one month in advance. At the balance sheet date, you will always have one month’s benefit for the coming period. So while the cash is already gone, the benefit is still there to be consumed. Any prepaid expenses included as current assets will have the future benefit used up within a year.
Short term liabilities are obligations that require cash payment within a year. These might include bank lines of credit and other debt due within one year. It also includes accounts payable to suppliers, taxes payable to governments, etc. Anything where you need to make a cash payment within a year would be a short term, or current, liability.
Balance Sheets Reflect a Point in Time, But Not the Future
When assessing the liquidity of a person or company, remember that any balance sheet analysis reflects only a single point in time.
In our example, ABC appears to be the most liquid company of the three from their financial data. But what if you read that ABC has entered into an agreement to purchase GHI’s interest in the real estate project. Suddenly ABCs excess cash is gone and GHI will be very liquid.
Or perhaps the balance sheet is as of December 31. All looks fine. Then on January 20, ABC declares a special dividend to shareholders and seriously erodes cash on hand.
What has already happened is very useful for investors and creditors.
But what really is important is what a company will do in the future.
If you plan to lend money or provide supplies on credit, you want to know if the company will have the ability to repay when the amounts are due. Not if they have the means in the past.
Learn how to read and understand financial statements of companies you intend to deal with, either as an investor or business counterpart. That shows how they have operated in the past and gives clues as to how they run a business.
Often, the best way to study financial statements is to start with the notes and work back to the actual statements. Much more useful investing information is usually contained within the notes. Yet most amateur investors ignore this key area.
But also follow news releases, management reports, prospectus information, competitor and industry trends, etc. to see where the company is going. What is safe today from a liquidity issue, may be fraught with peril in six months time.
Do not be the investor with the worthless bonds or the supplier who will never be paid.
Liquidity Safeguards
When investing in corporate debt, we will look at investment protection in some detail. For now, let me briefly point out some common measures to protect yourself when dealing with companies who owe you money.
The effectiveness of each measure is directly linked to how desperate the company is and the amount of leverage you possess. Conduct as much research as possible before investing, lending, or supplying to a company or individual.
Debt may be secured against general or specific assets. When you assume a home mortgage from the bank, the bank holds a lien on the house until the mortgage is repaid. That means that the bank gets the house if you do not pay them.
Debt may be prioritized. For example, senior debt is safer than junior debt. Senior debt will have priority of payout over subordinate issues in the event of bankruptcy. Senior debt moves you to the head of the creditor line should the company fail to pay its debts. The more subordinate, the less likelihood of a full payout.
With dividends, preferred shareholders will receive dividends before common shareholders.
There are a variety of other measures to improve the likelihood of being paid. We will consider them down the road.
Next we shall review liquidity risk for investors in companies.
A very important consideration if you ever want to buy and sell financial instruments.
